REPLACEMENT ANALYSIS Prof. Mercedes S. Ferrer-Alameda
DEFINITIONS
Defender: Actual Equipment
been evaluated Challen er: New e ui ment meant to be the replacement of the defender
DEFINITIONS
Marginal Cost: The cost of keeping the defender defender for one more year. This cost includes:
Operation & Maintenance (O & M) Insurance
Includes: loss in market value + lost interests
DEFINITIONS Minimum Cost Life (Economic Life): Number
of years years at which the EUAC EUAC is minimized. The minimum cost life is usually shorter that the useful life due to increasing O & M costs
E XAMPLE #1 An in-used equipment has a current market value of $5000. For the next 3 years, the market value will be $3000, $1000 $1000 and $500 respectively. A challenger can be purchased for $7500 with no salvage value at the end of three years. Operating and and maintenance maintenance costs for the defende defenderr are $1700 $1700 $2000 $2000 and $2500 $2500 for the next three three years. For the challenger, challenger, the O & M costs are $500, $ 1100 and $1300. Use MARR = 10%
Determine Marginal Cost of the defender Costo marginal marginal año 1:
Costo marginal marginal año 2
2000 + 2000*(.10) + 1700 2000 + 2000*(.10) + 2000
Costo marginal marginal año 3
500 + 500*(.10) + 2500
E XAMPLE #2: C ALCULATING ECONOMIC LIFE
The purchase price of a challenger is $15,000. Determine the economic life at 10%. The schedule of future operating costs and salvage values is:
Year
1
2
3
4
5
6
O&M
4500
4800
5700
6900
840 0
10200
S
9000
6900
5100
3900
330 0
2700
Year
O&M Costs
Annualized O&M Costs
1 2 3 4 5
$4,500.00 $4,800.00 $5,700.00 $6,900.00 $8,400.00 , .
4500 $4,642.86 $4,962.24 $5,379.77 $5,874.47 , .
SV 9000 6900 5100 3900 3300
Annualized Annualized Capital SV Investment ($15,000) ($9,000.00) ($3,285.71) ($1,540.79) ($840.34) ($540.53) .
$16,500.00 $8,642.86 $6,031.72 $4,732.06 $3,956.96 , .
EUAC $12,000.00 $10,000.00 $9,453.17 $9,271.49 $9,290.90 , .
OPPORTUNITY COST APPROACH Salvage value is considered as an opportunity cost for keeping the defender. Is a foregone foregone opportunity… It only answer the question on whether or not it is
Steps:
Identify the planning horizon: Usually taken as the remaining useful life for the defender If the planning horizon is finite, identify cash-flow for both: defender and challenger. Remember to consider salvage value for the defender as an initial investment Perform incremental PW analysis
E XAMPLE #3
Evaluate Example 1 assuming three years planning horizon Year
Cash Flow Defender
Cash Flow Challenger
Incremental
0 1 2 3
-$5,000.00 -$1,700.00 -$2,000.00 -$2,500.00
-$7,500.00 -$500.00 -$1,100.00 -$1,300.00
-$2,500.00 $1,200.00 $900.00 $1,200.00
Incremental PW(12%)
$143.04
Incremental analysis results in a positive PW, the defender should be replaced NOW
REPLACEMENT STRAT ATE EGIES UNDER THE INFINITE PLANNING HORIZON Answer the question about WHEN should the defender be replaced Steps:
Compute and compare the cost at economic lives for both: the defender (AECD* ) and the challenger (AECc* ) If AECD* < AECC* , the defender should be kept, at least until the economic is reached. Otherwise, the defender should be replaced now If the defender should be kept, determine when should it be replaced, after the economic live is finished. Calculate the marginal cost and compare to the AECC* If MC< AECC*, keep the defender for one more year Repeat procedure until MC > AEC C*
E XAMPLE #4 A grinder was was purchased purchased 3 years ago ago for $40,000. It has provided adequate service but an improved version is now available for $35,000 which will reduce operating costs and cut inspection expenses.
shown below. Should the replacement be made at at a MARR = 15%? If the service will be needed for only 4 more years, will your decision change?
Year
Defender O&M
0
Challenger S
O&M
12000
S 35000
1
3400
7000
200
30000
2
3900
4000
1000
27000
3
4600
2500
1200
24000
4
6500
1000
1500
20000
5
2000
19000
6
2000
18000
Economic Life Analysis for the Defender
Year 1 2 3 5 6
O&M Costs
Annualized O&M Costs
$ 3 , 4 0 0 .0 0 $ 3 , 9 0 0 .0 0 $ 4 , 6 0 0 .0 0 , .
$ 3 , 4 0 0 .0 0 $ 3 , 8 8 3 .8 7 $ 4 , 2 7 9 .0 8 , .
SV 700 0 400 0 250 0
Annualized SV
Annualized Opportunity Cost ($12,000)
($7,000.00) ($1,860.47) ($719.94) .
$ 1 3 , 8 0 0 .0 0 $ 7 , 3 8 1 .4 0 $ 5 , 2 5 5 .7 2 , .
EUAC $ 1 0 , 2 0 0 .0 0 $ 9 , 4 0 4 .8 0 $8,814.86 , .
Economic Life Analysis for the Challenger
Year
O&M Costs
Annualized O&M Costs
1 2 3 4 5 6
$200.00 $1,000.00 $1,200.00 $1 500.00 $2,000.00 $2,000.00
200 $572.09 $752.92 $902.53 $1,065.30 $1,172.08
SV 30000 27000 24000 20000 19000 18000
Annualized Capital Investment Annualized SV ($35,000) ($30,000.00) ($12,558.14) ($6,911.45) $4 005.31 ($2,818.00) ($2,056.26)
$40,250.00 $21,529.07 $15,329.19 $12 259.29 $10,441.04 $9,248.29
EUAC $10,450.00 $9,543.02 $9,170.66 $9 156.51 $8,688.35 $8,364.11
EUAC at Economic Life for the Challenger is lower l ower than EUAC at Economic Life for the Defender. The Defender should be replaced NOW
E XAMPLE #5 Assume defender in example #1 can be replaced with challenger in example #2. Should the inused equipment be replaced now?
Planning Planning horizon? horizon? – No plannin planning g horizon horizon Calculate cost at Economic Life for the defender
Economic Life Analysis for the Defender
Year
O&M Costs
Annualized O&M Costs
1 2 3
$ 1 , 7 0 0. 0 0 $ 2 , 0 0 0. 0 0 $ 2 , 5 0 0. 0 0
$1,700.00 $1,842.86 $2 $ 2,041.39
SV
Annualized SV
3000 1000 500
$3,000.00 $476.19 $151.06
Annualized Opportunity Cost ($5,000)
EUAC
$5,500.00 $2,880.95 $2,010.57
$10,200.00 $5,200.00 $4,203.02
Econ Econom omic ic Life Life Anal Anal sis sis for for the the Cha Chall llen en er
Year
O&M Costs
Annualized O&M Costs
1 2 3 4 5 6
$4,500.00 $4,800.00 $5,700.00 $6,900.00 $8,400.00 $10,200.00
4500 $4,642.86 $4,962.24 $5,379.77 $5,874.47 $6 $6,435.09
SV 9000 6900 5100 3900 3300 2700
Annualized Annualized Capital SV Investment ($15,000) ($9,000.00) ($3,285.71) ($1,540.79) ($840.34) ($540.53) ($349.94)
$16,500.00 $8,642.86 $6,031.72 $4,732.06 $3,956.96 $3,444.11
EUAC $12,000.00 $10,000.00 $9,453.17 $9,271.49 $9,290.90 $9,529.26
OTHER CONSIDERATIONS: TRADE IN A second challenger competes with the defender in example 1. This challenger has a purchase price of $12000, but $6000 is offered for the defender as tradein and the seller guarantees that operating costs will be no more more than than $800 $800// ear ear fo forr the the firs firstt 5 ears ears.. Should the offer be accepted when the required rate of return is 10% and a salvage value of $2000 at the end of the challenger’s challenger’s 5-years economic life?
Use a No-Planning Horizon approach
OTHER CONSIDERATIONS: TRADE IN The initial investment for the challenger must be reduced on $1000, that represents the real trade-in advantage EUAC (challenger) = (12,000-1000) (A/P, 10%,5) , , +
EUAC(Challenger) = $3,374.18 $3,374.18
Challenger should be selected
PRACTICE
Current in-use equipment can be sold in the market for $5,000, however to keep it in service it will require an immediate overhaul for $1,200. Operating costs are estimated in $2,000 for the next year, y ear, expected to increase in $2,500 per year thereafter. Future market values are ex ected ected to decli decline ne in $1000 $1000 er ear New machine cost $10,000 and will have operating costs of 1,800 on the first year, increasing by $800/year $ 800/year thereafter. The expected salvage value is $6000 for the t he first year, and will decline 15% each year Using an MARR = 15%, determine when the defender defende r should be replaced
OTHER CONSIDERATIONS: T AXES
To perform a Replacement-After Tax Analysis, several considerations are important:
For the defender: Current opportunity cost will be affected (positively or negatively) by the gains or losses at the selling transaction unde r the current If the in-used machine is sold by a value under book-value, a loss may be claim, resulting in tax savings (a benefit). This will will have the effect of reducing the the Opportunity Cost v alue over the current If the in-used machine is sold by a value book-value, a loss may be claim, resulting in additional tax expense. This will have the effect of increasing increasing the Opportunity Cost Perform an After-Tax cash flow including the above considerations:
E XAMPLE #6
Machintosh Printing, Inc., purchased a $20,000 printing machine two years ago. The company expected this machine to have five-year useful life and salvage value valu e of $5000. The company spent $5000 last year on repairs, and current operating costs are running at a rate of $8000/yr. Fur Further thermo morre the the ant antic icii ate ated salv salva a e valu valuee has has been been reduced to $2500 at the end of the remaining useful life. In addition, the company has found that the current machine has a market value of $10,000 today. Suppose that initial $20,000 in capital expenditure was setup to be depreciated using seven-years MACRS. If the company’s marginal income tax rate is 40%, determine the after-tax cash flow, assumig you keep the defender def ender
Calculate Opportunity Cost: Benefit losses if the the defender in kept
Current selling price + Tax impact Current market value: $10,000
Determine taxable income or loss from fr om disposal Selling g price price – Book Book Value Value Sellin value: Initial Initial investment investment – up to date depreciation depreciation Book value: $20,000 – ($2858 ($2858 + 4898/2) 4898/2) = $14,69 $14,693 3 $20,000 Depreciation for second year was divided by two because MACRS requires the assumption that ALL TRANSACTIONS occur at the mid of the year
